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Hedging Disney Ahead Of Earnings

If guests have the nerve to die, they wait, like unwanted calories, until they’ve crossed the line and can do so safely off the property. – The Project On Disney, via Snopes Disney: Estimize Versus Value Investor’s Edge With Disney (NYSE: DIS ) reporting earnings after the close, the nearly 1,200 Disney analysts reporting to Estimize collectively predict the company will beat Wall Street’s consensus earnings estimate, as the graph below shows. Click to enlarge The Estimize consensus earnings estimate shown above, $1.46, is 6 cents ahead of the Wall Street consensus of $1.40. Since its analysts include private investors as well as those from independent research shops, buy-side firms, and sell-side firms, Estimize says its estimates tend to be more accurate than those from Wall Street analysts alone. On the bearish side is Seeking Alpha premium author J Mintzmyer, who runs the Seeking Alpha Marketplace service Value Investor’s Edge . In a Pro Research column ( Time To Short Disney ), Mintzmyer argued the stock was “horribly expensive” (in the comments, Mintzmyer clarifies that, while he still finds the stock overvalued, he is no longer short Disney and feels there are better short opportunities available now). Limiting Downside Risk For Disney Longs For Disney longs boosted by the bullish Estimize earnings prediction, but looking to hedge their downside risk over the next several months, we’ll look at a couple of ways of doing so below the refresher on hedging terms. Refresher On Hedging Terms Recall that puts (short for put options) are contracts that give an investor the right to sell a security for a specified price (the strike price) before a specified date (the expiration date). And calls (short for call options) are contracts that give an investor the right to buy a security for a specified price before a specified date. Optimal puts are the ones that will give you the level of protection you want at the lowest cost. A collar is a type of hedge in which you buy a put option for protection, and at the same time, sell a call option, which gives another investor the right to buy the security from you at a higher strike price by the same expiration date. The proceeds from selling the call option can offset at least part of the cost of buying the put option. An optimal collar is a collar that will give you the level of protection you want at the lowest cost while not capping your possible upside by the expiration date of the hedge by more than you specify. In a nutshell, with a collar, you may be able to reduce the cost of hedging in return for giving up some possible upside. Hedging Disney With Optimal Puts We’re going to use Portfolio Armor’s iOS app to find an optimal put and an optimal collar to hedge Disney, but you don’t need the app to do this. You can find optimal puts and collars yourself by using the process we outlined in this article if you’re willing to take the time and do the work. Whether you run the calculations yourself using the process we outlined or use the app, an additional piece of information you’ll need to supply (along with the number of shares you’re looking to hedge) when scanning for an optimal put is your “threshold”, which refers to the maximum decline you are willing to risk. This will vary depending on your risk tolerance. For the purpose of the examples below, we’ve used a threshold of 15%. If you are more risk-averse, you could use a smaller threshold. And if you are less risk-averse, you could use a larger one. All else equal, though, the higher the threshold, the cheaper it will be to hedge. Here are the optimal puts as of Monday’s close to hedge 200 shares of DIS against a greater-than-15% drop by late October. As you can see at the bottom of the screen capture above, the cost of this protection was $424, or 2.01% of position value. A few points about this hedge: To be conservative, the cost was based on the ask price of the put. In practice, you can often buy puts for less (at some price between the bid and ask). The 15% threshold includes this cost, i.e., in the worst-case scenario, your DIS position would be down 12.99%, not including the hedging cost. The threshold is based on the intrinsic value of the puts, so they may provide more protection than promised if the investor exits after the underlying security declines in the near term, when the puts may still have significant time value . Hedging Disney With An Optimal Collar When searching for an optimal collar, you’ll need one more number in addition to your threshold, your “cap,” which refers to the maximum upside you are willing to limit yourself to if the underlying security appreciates significantly. A logical starting point for the cap is your estimate of how the security will perform over the time period of the hedge. For example, if you’re hedging over a five-month period, and you think a security won’t appreciate more than 6% over that time frame, then it might make sense to use 6% as a cap. You don’t think the security is going to do better than that anyway, so you’re willing to sell someone else the right to call it away if it does better than that. We checked Portfolio Armor’s website to get an estimate of Disney’s potential return over the time frame of the hedge. Every trading day, the site runs two screens to avoid riskier investments on every hedgeable security in the U.S., and then ranks the ones that pass by their potential return. Disney didn’t pass the two screens, do the site didn’t calculate a potential return for it. So we looked at Wall Street’s price targets for the stock via Yahoo Finance (pictured below). We usually work with the median target, but in this case, it’s pretty low relative to the price of the stock. The $110.50 12-month price target represents about a 2% potential return between now and late October. On the other hand, the high target of $130 implies a return of about 9.6% over that time frame. By using a cap of 9%, we were able to eliminate the cost of the hedge in this case, so we used that. As of Monday’s close, this was the optimal collar to hedge 200 shares of DIS against a greater-than-15% drop by late October while not capping an investor’s upside at less than 9% by the end of that time period. As you can see in the first part of the optimal collar above, the cost of the put leg was $328, or 1.56% of position value. But if you look at the second part of the collar below, you’ll see the income generated by selling the call leg was a bit higher: $364, or 1.73% of position value. So, the net cost was negative, meaning an investor opening this collar would have collected an amount equal to $36, or -0.17% of position value. Two notes on this hedge: Similar to the situation with the optimal puts, to be conservative, the cost of the optimal collar was calculated using the ask price of the puts and the bid price of the calls. In practice, an investor can often buy puts for less and sell calls for more (again, at some price between the bid and the ask), so in reality, an investor would likely have collected more than $36 when opening this collar. As with the optimal puts above, this hedge may provide more protection than promised if the investor exits after the underlying security declines in the near future, due to time value (for an example of this, see this recent article on hedging Apple (NASDAQ: AAPL ), Hedging Apple ). However, if the underlying security spikes in the near future, time value can have the opposite effect, making it costly to exit the position early (for an example of this, see this article on hedging Facebook (NASDAQ: FB ), Facebook Rewards Cautious Investors Less ). Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Hedge After Reading

Summary A JP Morgan study found that 40% of stocks since 1980 have suffered “catastrophic losses”, meaning declines of 70% or more without recovering. Although JP Morgan calls for diversification in response, the statistic suggests diversification’s ability to ameliorate stock-specific risk is limited: what if 40% of your stocks suffer catastrophic losses? Hedging can prevent catastrophic losses, but its cost raises questions about when it makes sense to hedge. We offer two rules to clarify the tradeoffs and a sample hedged portfolio. Why Consider Hedging Why consider hedging securities at all? Why not just weather declines and wait for prices to recover? One answer is that often security prices never recover. According to a JP Morgan (NYSE: JPM ) report shared by Wall Street Journal reporter Morgan Housel (“Falling from grace: catastrophic losses in Russell 3000 prices”), since 1980, 40% of stocks have suffered permanent, catastrophic losses, meaning they fell at least 70%, and never recovered (Morgan Housel is pictured below; the illustration is from his Twitter (NYSE: TWTR ) profile page ). As the pull-quote below, taken from the JP Morgan report, notes, catastrophic losses aren’t confined to recessions; they happen all the time. The report goes on to note that different sectors suffer higher percentages of catastrophic losses at different times. For example, the oil price collapse of the early 1980s led to more than 40% of energy companies suffering catastrophic declines during that period, as the graph below from the report shows. Bear in mind that the graph above goes to the end of 2014. If the recent rout in oil continues, it’s possible we’ll see another spike in catastrophic loss rates for energy companies going forward. Hedging, Diversifying, or Holding Cash Given how common catastrophic losses in stocks have been, the first answer that may come to mind when considering when it makes sense to hedge is, “when you want to avoid catastrophic losses”, but that’s a bit too facile. After all, you can limit such losses without hedging: for example, by holding high levels of cash. Another way often mentioned to limit stock-specific risk without hedging individual holdings is to diversify; in fact, the JP Morgan report itself suggests this in the pull-quote below. If you’re confident that diversification can sufficiently limit your stock-specific risk, then you could simply diversify, and focus your risk management on ways to limit your market risk, which diversifiction doesn’t ameliorate. We discussed ways to do that in a previous article, How To Limit Your Market Risk . But, after having read the JP Morgan paper, we’re left with this question: what happens if you’re diversified and 40% of your stocks suffer catastrophic losses? It would seem that diversification alone might not protect your portfolio against a decline you would find unacceptable. So, we’re back to considering hedging individual positions, or holding cash. Holding Cash as an Alternative to Hedging Holding cash has the advantages of being simple, and cost-free (not counting opportunity cost). If, for example, the maximum drawdown you’re willing to risk is 10%, and you have 90% of your money in cash, then if everything you own with the other 10% suffers catastrophic losses, in the worst case scenario, your portfolio won’t be down more than 10%. Seeking Alpha contributor William Koldus, CFA, CAIA suggested a 90% cash portfolio in a recent article (“Why A 90% Cash Portfolio Will Likely Outperform”), but investors seeking higher returns may not want to hold such a high cash position. For those investors, a portfolio where each position is hedged may be preferable, so we’ll look at a couple of rules to guide their hedging and security selection decisions in constructing such a portfolio. Then, we’ll offer a sample hedged portfolio. These rules may seem obvious in hindsight, but could prove to be useful additions to your ” latticework of mental models “. Rule #1: Count The Cost Of Hedging Recall the example we mentioned above of an investor unwilling to risk a drawdown of more than 10%. We’ll refer to that 10% as his decline “threshold”. Let’s say that investor was using put options to hedge. Put options, for those who may benefit from a refresher, are contracts that give an investor the right to sell a security for a specified price (the strike price) before a specified date (the expiration date), regardless of where the market price of the security is at that time. For example, if you have a put option with a strike price of $10, and the price of your underlying stock drops to less than $5, you can still sell your stock for $10 per share.* Given the time frame over which he was looking to hedge, our hypothetical investor would want to find the put options that would protect him against a greater-than-10% decline at the lowest cost. When doing so, he’d need to take into account the cost of the hedge as it applies to his threshold: for example, let’s say there was a put option with a strike price 10% below the current market price of his stock, but it would cost 5% of his position value to buy it. If he bought that bought option, he’d actually be risking a 15% drawdown, taking into account the cost of the hedge. If the investor were using Portfolio Armor’s hedging app to find the optimal puts for a 10% threshold, the app would do this automatically, so, in the worst case scenario, the market value of the investor’s underlying stock, plus its hedge (minus the initial cost of the hedge) would total no less than 90% of the starting market value of his underlying stock position. The cost of hedging can also be used as a way to screen out some potentially bad investments, as we elaborated on in a recent article, 2 Screens To Avoid Bad Investments . Rule #2: Potential Return Must Exceed Hedging Cost Potential return here refers to an estimate of how well the security will perform over the time frame of the hedge. Let’s say that time frame is 6 months, and your threshold remains 10%, that is, you are unwilling to risk a drawdown of more than 10% over 6 months. And let’s you found a hedge that will limit the decline in your underling security to no more than 6%, and the hedge costs 4%, so it fulfills Rule #1 (you won’t be down more than your threshold, 10%, in a worst case scenario). So far, so good. But what if you estimate your underlying security has a potential return of 2% over the next six months? Then this hedged position fails Rule #2, because the potential return is less than the hedging cost: you’re potential return, net of hedging cost (your net potential return) in this case would be -2%. At a minimum, you would want your net potential return to be positive, but, ideally, you’d want to assemble a portfolio of hedged positions where the net potential returns are as high as possible, given your threshold (all else equal, the larger your threshold, i.e., the larger the drawdown you are willing to risk, the cheaper it will be to hedge, and the cheaper it is to hedge, the higher your net potential returns will be). Putting It All Together To implement this approach, for every security in your universe, you’d want to calculate the cost of hedging it against your decline threshold, eliminating all that are too expensive to hedge in that manner. Then you’d want to estimate potential returns for all of the securities that weren’t too expensive to hedge, and subtract the hedging costs from your potential return estimates, to get net potential returns. Then, you’d rank the securities by net potential return, and buy and hedge round lots (numbers of shares divisible by 100) of a handful of the ones with the highest net potential returns. That’s essentially what Portfolio Armor’s hedged portfolio construction tool does, though it adds an additional fine-tuning step. After rounding down dollar amounts to allocate to round lots of a handful of securities with the highest net potential returns in its universe (which consists of every optionable stock and exchange traded product in the US), it searches for what we call a “cash substitute”: that’s a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor’s downside limited according to his specifications. You could use a similar approach, or you could simply allocate left over cash to one of the securities you selected in the previous step. A Sample Hedged Portfolio Below is a hedged portfolio designed for an investor with $500,000 to invest who is unwilling to risk a drawdown of more than 10% over the next 6 months. This hedged portfolio was generated by Portfolio Armor using data as of Monday’s close. Why Those Particular Securities? After it applied its “2 screens to avoid bad investments” to its universe, eliminating inauspicious ones, the site sorted the remaining securities by potential return, net of hedging costs, or net potential return. It included Amazon (NASDAQ: AMZN ), Activision Blizzard (NASDAQ: ATVI ), Ctrip (NASDAQ: CTRP ), NVIDIA (NASDAQ: NVDA ), and Public Storage (NYSE: PSA ), because those had the highest net potential returns when hedged against > 10% declines. In its fine-tuning step, it added Regeneron Pharmaceuticals (NASDAQ: REGN ) as a cash substitute, because it had one of the highest net potential returns when hedged as one. Let’s turn our attention now to the portfolio level summary. Worst-Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before the hedges expired, the portfolio would decline 8.6%. Per Rule #1, that 8.6% maximum drawdown is inclusive of the 3.1% hedging cost, i.e., the portfolio value would only be down 5.5% not including the hedging cost, in a worst case scenario. Best-Case Scenario At the portfolio level, the net potential return is 12.74%. This represents the best-case scenario if each underlying security in the portfolio meets or exceeds its potential return. A More Likely Scenario The portfolio level expected return of 4.6% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns. Each Security Is Hedged Note that in the portfolio above, each underlying security is hedged. Public Storage is hedged with an optimal put; Regeneron is hedged as a cash substitute, with an optimal collar with its cap set at 1%; and the rest of the securities are hedged with optimal collars with their caps set at their potential returns. Here’s a closer look at the hedge for Public Storage: As you can see in the screen capture above (image via the Portfolio Armor iOS app ), the cost of the PSA hedge was $2,280, or 4.55% of position value. To be conservative, the cost here was calculated using the ask price of the puts. In practice, an investor can often buy puts for less (at some price between the bid and ask), so the actual cost to purchase these puts would likely have been less. The cost of the other hedges in the portfolio was calculated in a similarly conservative manner. —————————————————————————– *Using a put option to sell an underlying security at the strike price is called “exercising” the option. In practice, you can often get the same level of protection, or better, by selling your underling security and your put option at their respective market prices than by exercising your put option. Depending on how far out the expiration date of your put option is (how much “time value” it has, in options terminology), the put option will trade for at least its “intrinsic value”, which is the difference between the option’s strike price ($10, in our example above) and the market price of the stock ($5, in the same example). So the option will trade for at least $5 in this scenario. But it may trade for more, if options market participants believe the underlying security may drop further (increasing the intrinsic value of the option) before the option expires.

Investing Alongside Buffett, Klarman, And Other Top Investors While Limiting Your Risk

Summary An investor can precisely limit his risk while maximizing his expected return by creating a hedged portfolio. When creating a hedged portfolio, you can start from scratch or start with a list of top picks. We lay out the second method here and provide an example. The example hedged portfolio was designed for investors willing to risk a maximum drawdown of 20%. Investors with lower risk tolerances can use a similar process, though their expected returns would likely be lower. Investing In An Uncertain Market Investors could be forgiven for wanting to limit their risk given the uncertainty about the current economic environment. Let’s recap the latest bit of news adding to the uncertainty, and then look at a way we can invest alongside some of the world’s best investors while limiting our risk. Reactions to the August jobs report released on Friday varied. The White House highlighted the positive: Our economy has now added 8.0 million jobs over the past three years, a pace that has not been exceeded since 2000. And while the economy added jobs at a somewhat slower pace in August than in recent months, the unemployment rate fell to 5.1 percent-its lowest level since April 2008-and the labor force participation rate remained stable. And the Wall Street Journal pointed out the dark cloud inside that silver lining: The labor-force participation rate stayed the same last month at 62.6%.The participation rate-the share of the population either working or actively looking for work-has been dropping for several years and is near levels last consistently recorded in the late 1970s, a time when women were entering the workforce in larger numbers. The latest reading is a result of the labor force shrinking by 41,000 last month, despite other signs of an improving jobs market. As the New York Times noted , the jobs report gave ammunition to both sides of the Fed rate debate, but, as Seeking Alpha news editor Carl Surran summarized it, the market’s verdict seemed to be negative, with the major market indexes down on Friday and all ten sectors in the red. Dealing With Uncertainty After all the analysis, no one knows what direction the market will take from here. One way to deal with uncertainty about market direction is to invest in a handful of securities you think will do well, and hedge against the possibility that you end up being wrong. That approach is systematized in the hedged portfolio method, which we detailed in a previous post (“Backtesting The Hedged Portfolio Method”). One advantage of the hedged portfolio method is that it can accommodate a broad range of risk tolerances. If you can tolerate a drawdown of more than 20%, our research (summarized in the previous post we mentioned above) suggests that with our security selection method you can achieve returns as good or better than the market over time with less risk. Maybe You Can Do Better It’s possible you can get even better returns with the hedged portfolio method by selecting your own securities. And if you’re going to do that, a good starting place for ideas is to look at what some of the best investors in the world have been buying. Seeking Alpha contributor and hedge fund manager Chris DeMuth, Jr. did just that in a recent article (“Best Q2 Picks From Top Investors”). In that article, DeMuth examined reported buys from leading investors and highlighted a number of them. These were the stocks, along with the investors who bought them: SunEdison Semiconductor (NASDAQ: SEMI ) – Seth Klarman. Precision Castparts (NYSE: PCP ) – Warren Buffett SunEdison (NYSE: SUNE ) – David Einhorn Perrigo (NYSE: PRGO ) – Stephen Mandel (former analyst for Julian Robertson) Williams (NYSE: WMB ) – Dan Loeb Danaher (NYSE: DHR ) – John Griffen (another former protege of Julian Robertson) Time Warner Cable (NYSE: TWC ) – John Paulson Baker Hughes (NYSE: BHI )- Jeff Ubben Shire (NASDAQ: SHPG ) – Leon Cooperman Office Depot (NASDAQ: ODP ) – Richard Perry Humana (NYSE: HUM ) – Larry Robbins Cigna (NYSE: CI ) – Andreas Halvorsen Altera (NASDAQ: ALTR ) – Andrew Spokes Icahn Enterprises (NASDAQ: IEP ) – Carl Icahn Brookdale Senior Living (NYSE: BKD ) – Barry Rosenstein T-Mobile (NYSE: TMUS ) – Phillippe Lafont DeMuth’s article is worth a read for some color on these stocks and investors (particularly, the less well-known investors). But we’ll start with the assumption that most of these are solid stocks, and we’ll use them as a starting point to construct a hedged portfolio for an investor who is unwilling to risk a drawdown of more than 20%, and has $1 million he wants to invest. First, though, address the issue of risk tolerance, and how it affects potential return. Risk Tolerance and Potential Return All else equal, with a hedged portfolio, the greater an investor’s risk tolerance — the greater the maximum drawdown he is willing to risk (his “threshold”, in our terminology) – the higher his potential return will be. So, we should expect that an investor who is willing to risk a 20% decline will have a chance at higher returns than one who is only willing to risk, say, a 10% drawdown. Constructing A Hedged Portfolio In the previous article mentioned above, we discussed a process investors could use to construct a hedged portfolio designed to maximize potential return while limiting risk. We’ll recap that process here briefly, and then explain how you can implement it yourself. Finally, we’ll present an example of a hedged portfolio that was constructed this way with an automated tool. The process, in broad strokes, is this: Find securities with high potential returns (we define potential return as a high-end, bullish estimate of how the security will perform). Find securities that are relatively inexpensive to hedge. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns). Hedge them. The potential benefits of this approach are twofold: If you are successful at the first step (finding securities with high potential returns), and you hold a concentrated portfolio of them, your portfolios should generate decent returns over time. If you are hedged, and your return estimates are completely wrong, on occasion — or the market moves against you — your downside will be strictly limited. How to Implement This Approach Finding promising stocks In this case, we’re going to start with the list of Q2 best picks curated by Chris DeMuth. To quantify potential returns for these stocks, you can, for example, use analysts’ price targets for them and then convert these to percentage returns from current prices. In general, though, you’ll need to use the same time frame for each of your potential return calculations to facilitate comparisons of potential returns, hedging costs, and net potential returns. Our method starts with calculations of six-month potential returns. Finding inexpensive ways to hedge these securities First, you’ll need to determine whether each of these top holdings are hedgeable. Then, whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-20% decline over the time frame covered by your potential return calculations (our method attempts to find optimal static hedges using collars as well as protective puts going out approximately six months). And you’ll need to calculate your cost of hedging as a percentage of position value. Selecting the securities with highest net potential returns In order to determine which securities these are, out of the list above, you may need to first adjust your potential return calculations by the time frame of your hedges. For example, although our method initially calculates six-month potential returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our potential return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you’ll need to subtract the hedging costs you calculated in the previous step from the potential returns you calculated for each position, and exclude any security that has a negative potential return net of hedging costs. Fine-tuning portfolio construction You’ll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs, so if you’re going to include a handful of securities from the sort in the previous step and you have a relatively small portfolio, you’ll need to take into account the share prices of the securities. Another fine-tuning step is to minimize cash that’s leftover after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won’t need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash you can potentially boost returns. In this step, our method searches for what we call a “cash substitute”: that’s a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor’s downside limited according to his specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step. Calculating Expected Returns While net potential returns are bullish estimates of how well securities will perform, net of their hedging costs, expected returns, in our terminology, are the more likely returns net of hedging costs. In a series of 25,412 backtests over an 11-year time period, we determined two things about our method of calculating potential returns: it generates alpha, and it overstates actual returns. The average actual return over the next six months in those 25,412 tests was 0.3x the average potential return calculated ahead of time. So, we use that empirically derived relationship to calculate our expected returns. An Automated Approach Here we’ll show an example of creating a hedged portfolio starting with Chris DeMuth’s best Q2 picks using the general process described above, facilitated by the automated hedged portfolio construction tool at Portfolio Armor . In the first step, we enter the ticker symbols in the “Tickers” field, the dollar amount of our investor’s portfolio (1000000), and in the third field, the maximum decline he’s willing to risk in percentage terms (20). In the second step, we are given the option of entering our own return estimates for each of these securities. One of these securities, PCP, appeared in a hedged portfolio in a previous article (“An Alternative To Cash For A Risk Averse Investor), and there, we used Portfolio Armor’s calculated potential return for it. In this case, for illustration purposes, we’ll enter a potential return for it based on the assumption that the Berkshire Hathaway deal closes at the announced price of $235 per share. For the other securities, we’ll let Portfolio Armor supply its own potential returns. A couple minutes after clicking the “Create” button, we were presented with the hedged portfolio below. The data here is as of Friday’s close. Why These Particular Securities? The site included all of the entered securities for which it calculated a positive potential return, net of hedging costs. Interestingly, one of the stocks it rejected, Icahn Enterprises , is one Chris DeMuth mentioned as a short position earlier this year, as he noted in his Best Q2 Picks article. In its fine-tuning step, Portfolio Armor added Google (NASDAQ: GOOG ) as a cash substitute. Let’s turn our attention now to the portfolio level summary for a moment. Worst-Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before the hedges expired, the portfolio would decline 19.67%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -1.03%, meaning the investor would receive more income in total from selling the call legs of the collars on his positions than he spent buying the puts. Best-Case Scenario At the portfolio level, the net potential return is 13.44% over the next six months. This represents the best-case scenario, if each underlying security in the portfolio meets or exceeds its potential return. A More Likely Scenario The portfolio level expected return of 4.63% represents a conservative estimate, based on the historical relationship between our calculated potential returns and backtested actual returns. However, since these securities are picks of some of the world’s best investors, it’s possible Portfolio Armor is underestimating their returns over the next six months. By way of comparison, if you created a hedged portfolio on Friday using the same dollar amount ($1,000,000) and decline threshold (20%), but without entering any ticker symbols (i.e., you let Portfolio Armor pick the securities), the expected return for that hedged portfolio would have been 7.97%. That hedged portfolio would have only had one primary security in common with this one; as you can probably guess from the potential returns shown in the hedged portfolio above, that security was Advance Auto Parts. Each Security Is Hedged Note that each of the above securities is hedged. Google, the cash substitute, is hedged with an optimal collar with its cap set at 1%; Advance Auto Parts and Precision Castparts are hedged with optimal puts; and the remaining securities are hedged with optimal collars with their caps set at each underlying security’s potential return. Here is a closer look at the hedge for Advance Auto Parts: The cap field above is blank, because this isn’t a collar. Portfolio Armor used optimal puts in this case instead of an optimal collar because the position had a higher net potential return this way (it calculated the net potential returns both ways for each of the primary positions in the portfolio). As you can see at the bottom of the image above, the cost of this hedge was $2,500, or 2.90% of position value.[i] Note that, although this hedge had a positive hedging cost, the hedging cost for the portfolio as a whole was negative. Possibly More Protection Than Promised In some cases, hedges such as the ones in the portfolio above can provide more protection than promised. For an example of that, see this recent instablog post on hedging Tesla (NASDAQ: TSLA ). Hedged Portfolios For Smaller Investors The hedged portfolio shown above was designed for someone with $1 million to invest, but the same process, with a couple of minor adjustments, can be used for those with smaller amounts to invest. We walked through creating a hedged portfolio for someone with $30,000 to invest in an article last month (“Keeping a Small Nest Egg from Cracking”). [i] To be conservative, the cost of the put protection was calculated using the ask price of the puts. In practice, an investor can often buy puts for less than the ask price (i.e., at some price between the bid and ask). So, in practice, an investor would likely have paid less than $2,880 for this hedge. A similarly conservative approach was used for calculating the costs of all of the hedges in this portfolio (with the cost of puts calculated at the ask and the income from calls calculated at the bid). Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.